Performance Pay: Lessons from Personnel Economics

1. Performance Pay: Lessons from Personnel Economics Compensation, Work Practices and Productivity Steyr July, 2003 Edward P. Lazear Stanford University

2. Today’s talk • All pay is performance pay • Traditional incentive pay • Uses - Sorting and incentives • Results • Relative pay • Intrinsic motivation Edward P. Lazear Stanford University

3. All Pay is Performance Pay • Issue of structure and formula • Piece rates, commissions • Hourly wages, annual salaries • Which variables determine best structure? • Measurability • Heterogeneity • Complexity Edward P. Lazear Stanford University

4. Pay Forms Pay on input or output? • Input • Hourly wage • Annual salary • Effort related bonuses • Output • Piece rates • Sales commissions • Output related bonuses • Team compensation • Profit sharing • Stock and options Edward P. Lazear Stanford University

5. Input or Output? • Measurement costs and risk aversion • Output sometimes difficult to measure • Complex • Teams • Takes time to play out (R&D) • Education (earnings) • Proxies – Test scores • Output highly variable (risky projects) • When risk or measurement is an issue, pay on input • Input imperfect but often more available measure of what is desired • Input is non-distorting Edward P. Lazear Stanford University

6. Discrete or Continuous? Edward P. Lazear Stanford University

7. Both Create Incentives • Discrete is strong in narrow range • Continuous is weak in any one range, but strong overall • Not “high-powered” v. “low powered” • Discrete well-suited to homogeneous workforce • Both induce sorting Edward P. Lazear Stanford University

8. Choice of Pay Structure Continuous (Heterogeneous Discrete (Homogeneous or Workforce) idiosyncratic workforce) Input Hourly wage paid Retainer paid to a lawyer (Output difficult to management consultant observe) Output Piece rate workers Non-commission salesperson (Output easy to observe) Edward P. Lazear Stanford University

9. A European Issue • Termination difficult • Suggests use of continuous over discrete Edward P. Lazear Stanford University

10. An Example: Team Incentives European Oil Company • Oil field on Arctic Ocean – great success • Head office in Anchorage – total failure • The lesson • Production versus managers? No • Peer pressure effective small groups Edward P. Lazear Stanford University

11. Results on “Performance Pay” for Managers • Abowd (1990) • 16,000 managers at 250 corporations • Additional 10% performance  400 to 1200 basis points on stock return • Leonard (1990) • Companies with long-term incentive plans had significantly higher R.O.E. • Kaplan (1994) • Japanese executives whose compensation is tied to performance are associated with companies with higher subsequent performance • Almost never find the reverse Edward P. Lazear Stanford University

12. Managerial Performance Pay • The “Puzzle” • If effective, why is the relation of pay to performance closer to zero than one? • Jensen & Murphy, • Hall and Leibman • Graziano and Parigi (Italian firms have similar low elasticities) • Explanations • Straw man • Every manager cannot own firm • Groves and other mechanisms have problems • Enough incentives if managers are risk averse (Haubrich) • Another reason for performance pay: Information for investors Edward P. Lazear Stanford University

13. Put Your Money Where Your Mouth Is or “Skin in the Game” • Venture capitalists require low base + performance pay • Wage = a + b (Output) • Incentive solution • b=1, a<0 • Sorting solution: Homogeneous managers • b very small, a slightly less than alternative • Always accepts positive profit project • Never accepts never profit project • Much evidence for this view (new, high tech firms use more) Edward P. Lazear Stanford University

14. Another Form of Performance Pay: Tournaments • Almost all managers face implicit if not explicit tournaments • Tournament defined as pay or non-monetary compensation function of relative performance Edward P. Lazear Stanford University

15. Tournaments • Goal of tournament theory • To explain salary hierarchy • To explain different patterns across industries and countries • Metaphor of tennis match • Compensation based on relative position • The larger the spread, the more effort • There is an optimal spread • Too much variation creates recruitment and cooperation problems Edward P. Lazear Stanford University

16. Mathematics Edward P. Lazear Stanford University

17. So… • Bigger raises create greater incentives • Use larger spread in “noisier” environments • Higher wage differentials in new and/or risky industries • Higher wage differentials in US than in Europe • But bigger raises  less teamwork Edward P. Lazear Stanford University

18. Evidence on Tournaments • Eriksson (1999) finds strong support of implied wage structure • O’Reilly, Crystal and Main: Promotion rates • Sports: Ehrenberg and Bognano and later Bronars, golf • Experiments: Bull, Schotter and Weigelt (1987) and Fehr and Falk (2002), Freeman, et. al. (2003), European Science Days students Edward P. Lazear Stanford University

19. More Evidence on Tournaments • Knoeber: Chickens • Drago and Garvey (1998) • Large raises for promotionbetter attendance in 23 Australian firms • Large raises associated with less sharing Edward P. Lazear Stanford University

20. Intrinsic and Extrinsic • Action on the margin • At some levels, makes no sense • Cut commissions so will work harder? Edward P. Lazear Stanford University

21. A Traditional Human Resources View The fundamental economic theory of motivation is based on assumptions of effort aversion (people will not expend effort unless paid to do so), opportunism (people, in the pursuit of their own interests, will often misrepresent their true preferences and engage in guile and deceit), and a lack of goal alignment (employees in organizations have different agendas than the owners and, therefore, incentive systems need to be designed to force people to do what is right for the good of the organization). In the economists’ view, people are assumed to be lazy, dishonest, and at odds with the goals of the managers. Although each of these assumptions may be valid in a specific situation, or for a particular individual (for instance, when managing economists themselves), none is likely to be right in most settings with normal human beings. - Charles O’Reilly and Jeffrey Pfeffer Edward P. Lazear Stanford University

22. An Example: Lazear’s Teaching Edward P. Lazear Stanford University

23. Demand and Supply Version Edward P. Lazear Stanford University

24. Conclusion • Performance pay: Not whether but what form • Input or output • Discrete or continuous • Relative or absolute • Output-based performance pay may be as important for selection as incentives • Rank-order based incentives are pervasive for managers • Manifestations • Promotions • Bonuses • Status and other non-monetary factors • Adverse effects on cooperation • Implicit if not explicit almost everywhere so understanding essential Edward P. Lazear Stanford University